One essential function of a contract or commercial agreement is to allocate risk between the parties.
Parties to contracts should, as a matter of course and at an early stage, undertake a risk management process to (1) identify risks and (2) allocate those risks.
In sophisticated contracts, the parties may jointly participate in developing a risk management matrix to reach a particular regime appropriate to the risks presented by the particular contract.
In most contracts however, the identification and allocation of risks falls to be negotiated between the parties in the course of determining the complete terms and conditions of their bargain.
A starting point is to understand what is ‘risk’.
The term ‘risk’ has a dictionary definition that is useful:
The Oxford English Dictionary defines risk as “the chance that is accepted in economic enterprise and considered the source of ….. profit”.
Risk has also been identified as “the probability of an event occurring coupled with the consequences if it does occur”.
These definitions look at risk from somewhat different viewpoints. The Oxford English Dictionary definition focusses on risk as an element in making profit, in the sense that if nothing is ventured, nothing is gained, and business people accept the risk of downside as part of the opportunity to make profit. Specifically, the activity is undertaken on the basis that the parties accept that the risk of failure or downside is overcome or outweighed by the possibility or probability of profit. This suggests the necessity to weigh-up the risk factors against the possible or probable profit.
The other definition is a more analytical definition in relation to the probability of occurrence and consequence of occurrence of the risk. This definition effectively deals with the consequence of risks occurring rather than the identification of the risks themselves in the first place. This is more a ‘downstream’ approach as distinct from an ‘upstream’ approach that is more indicated in the Oxford English Dictionary.
Different types of commercial transactions in different industry sectors give rise to different risks. The upstream task is to identify the risks in the particular specific transaction. Once the risks have been generally identified, it then falls to the parties to evaluate those risks.
That evaluation involves the likelihood or possibility of occurrence and the consequence of the risk occurring. Both aspects need to be given careful consideration and are important in the course of negotiating the terms of any contract.
It should be borne in mind that the risks for the parties in a contract are not identical and there will be different risks for the respective parties with different potentials for occurrence and differing consequences of occurrence.
It is therefore important for contracting parties to access and identify their own specific risks and evaluate probability of occurrence and consequence of occurrence, as well as undertaking similar analysis from the other side of the contract, as best they can.
This strategy will contribute to a more rational and commercial approach to resolving commercial conflicts between legal and financial outcomes that arise from the risk management analysis.